Profit sharing between shareholders: What you should be aware of

As a shareholder of a limited liability company, you are generally entitled to have your profit shares paid out after the end of a profitable business year. That may be easy if you are the sole shareholder. You get all the profits.

But what happens if there is more than one shareholder? Are you worried about profits not being fairly distributed and would like to know what you need to watch out for?

In this post, I have compiled the most important aspects that need to be considered to ensure the fair distribution of profits. I also warn you against a trap that many business owners fall into.

#1: First the theory: Shareholders and one condition

Shareholders are contractual partners who have contributed money to the company’s share capital. Only shareholders are entitled to receive profit shares.

Salaried employees – no matter what role they have in the company – receive a salary, bonuses, etc. but not profit shares.

Important: If the decision is made to distribute profits, shareholders always have a legal claim to the amounts paid out for the profit shares.

If you have a qualified majority in the company, then you are the shareholder who can determine the distribution of profits yourself and without the input of anyone else.

What happens if you do not hold the majority?

Then you only get a profit if the majority of the people who hold the company shares decide to distribute profits. This is different from a partnership.

Profit is the condition

In order for any profits to be distributed, the company itself must be profitable.

To know whether profits have been made, you need the balance sheet. Unless you still have profit carried forward from profitable previous years.

#2: Proportionate vs. disproportionate profit distribution

There is absolutely no reason to worry that profits will be distributed unfairly. This cannot happen.  Section 29, paragraph 3 of the German Limited Liability Companies Act (GmbH-Gesetz) stipulates the following in respect of profit distribution:

“Profits shall be distributed in proportion to the shares held in the business.”

Source: https://dejure.org/gesetze/GmbHG/29.html, May 2, 2018.

In practice this means: The way in which profits of the company are distributed is determined by  the number of shares in the company you own.

You can also define other rules on distribution in the articles of incorporation. This refers to the disproportionate or incongruent distribution of profits.

In other words: The way in which profit is distributed is not determined by the share held in the company but instead by the resolution on the distribution of profit.

But only if the articles of incorporation provide for the option of a disproportionate payout.

Performance-dependent profit share? Is that possible?

It is not possible to arrange the profit share in such a way that reflects your performance. This is because the profit of a company does not depend on the performance you have rendered.

The only way of doing this is to focus on the  salary. That means: Shareholders who perform better receive a higher salary, royalties or bonuses, etc.

Be careful not to confuse the two: Profit distribution is not the same as a salary payment.

The distribution of profits in a limited liability company is not to be deemed the same as salary payments. This is because salaries are paid out before profit distribution and reduce the profit subsequently available for distribution.

Taxation in case of profit distribution

The distributed profits you have received as part of the profit distribution must be taxed.

Put simply: 40 percent of the amount distributed is tax-free, while 60 percent is taxable and subject to your personal tax rate.

All in all, it is often the case that the total tax burden of a limited liability company amounts to 48 percent. This is six percent more than what could be payable in income tax.

#3: Variable profit shares: You must be aware of this to avoid falling into a trap.

If you would like to change the profit shares, the articles of incorporation need to be amended. This can only happen with the consent of every shareholder.

You must be particularly careful here to avoid falling into a trap. There are indeed limited liability companies that provide for disproportionate profit distributions in the articles of incorporation.

If you participate in such a company and buy a share, it may all come down to a single sentence on profit distribution in the articles of incorporation.

If you do not have a clued-up tax advisor who draws your attention to this point, you run the risk of receiving a share that is different to the one you had hoped for.

Conclusion: Fair profit distribution guaranteed by law

This post has shown that lawmakers have ensure that profits are fairly distributed. They are paid out either in relation to the number of shares held in the company or in another way as stipulated in the articles of incorporation (= disproportionate).

Above-average performance on the part of shareholders can only be remunerated by way of their salary. It is not permitted to summarily increase the profit distribution.

If you decide to participate financially in a company, you must pay close attention to the articles of incorporation. In case of doubt, ask your tax advisor.

Kind regards,

Thomas Breit

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